The first quarter of 2022 was the worst quarter in two years for both stocks and bonds. Behind the scenes, the bigger story was the bond market and higher interest rates. The bond market in general had its largest loss since 1980 while treasury bonds have had the worst quarter since they have tracked them (1926). New York Times April 4, 2022
The good news is that the US economy is extremely strong. Corporate earnings are robust and consumer spending is at an all-time high. The bad news is that this strength is making certain sectors of the economy overheat. The current job market is tighter than ever, and when coupled with soaring commodity prices it creates a situation in which the Federal Reserve needs to take action.
The Fed is attempting to put the brakes on the economy. How do they try and achieve a slowdown? They have two tools readily available. 1. Raise the Fed funds rate and 2. Unwind their inflated balance sheet by selling some of the bonds they purchased during the pandemic. Both tools will raise interest rates thus making borrowing more expensive and money less readily available. This will raise the cost of loans and mortgages. It will also make holding cash and bonds much more attractive. These changes all make taking business risks like capital improvements, M&A, and buying stocks all less attractive.
Our fixed income portfolios have withstood the big losses in the general market because we anticipated the rise in rates and had made appropriate strategic moves. We are now for the first time in years seeing some good opportunities in 2-5 year corporate and municipal individual bonds.
The Fed’s job is not as easy as it sounds. Will the Fed be able to thread the needle of slowing demand while not cause a prolonged recession? If you are ever going to raise rates while doing minimal damage to the economy, today's environment (earnings are solid, corporate, and municipal balance sheets are in excellent shape) seems like it is in good enough shape to resist falling into a deep recession. What are the possible outcomes for a Fed induced slowdown?
- No recession - an economic slowdown but continued earnings and economic growth (in our mind this has a high likelihood of occurring).
- Soft landing - a real slowdown that causes consumers to significantly slow spending resulting in a short shallow recession.
- Hard landing - unlikely but could happen if we get a real slowdown in spending coupled with some sort of geopolitical event.
If we think there is a possibility of recession in 2023 or beyond why own stocks? Stocks can certainly perform well in a rising interest rate environment. The chart below makes it clear we shouldn’t make wholesale changes to client portfolios.
We may not have a recession anytime soon (the Fed does enough to slow inflation but not overdo it). Remember nobody knows where the market is going in the short term, so best to own high quality investments that will serve our clients well in the long haul.